Goldman Sachs: Here’s What a Credit Downgrade Does to the US

When it comes to sellside research ideas (no matter how wrong) being mysteriously converted into official policy nobody, and we mean nobody in the world, is more effective at this “task” than Goldman Sachs (NYSE:GS). In addition to being a herd leader of all the other momos on Wall Street — with Deutsche Bank (NYSE:DB) being dead last, what Goldman wants, whether it is QE1, QE2, or the final layout of the eurozone bailout package, Goldman gets. Which is why people actually do care about Goldman’s research: not because it is right, it rarely if ever is, unless of course one gauges its success with the bonus pool for Goldman Sachs itself in which case it has been a massive success without fail, but because everyone in DC reads it as gospel, and whatever is advised is eventually implemented. Which is why even as we have skipped numerous analyses of what would happen to the US should its rating be cut, Goldman’s is a must read, not the least because Goldman finally puts all those economic illiterates who compares a US downgrade to that of US and assume off the bat that nothing bad can possibly happen. Wrong. Just ask Jan Hatzius: “It bears repeating that no two episodes are alike – nor is any historical episode a close parallel to current US circumstances.” And while even he admits he has no idea what will happen, he doesn’t get paid by the blank piece of paper so the Goldman economist did have to supply 4 summary conclusions of what will happen when the US is downgraded, sometime over the next 3-4 weeks: 1. A drop in equity markets, but probably a modest one, 2. Some weakening in the currency, 3. A steepening of the yield curve and a cheapening of Treasuries relative to OIS, 4. Some weakness in the financials sector. In other words, “we have no idea, but it won’t be good.” We totally agree. The full note is below for those whose brains aren’t petrified enough to assume that the Japanese downgrade is in any way remotely comparable to that of the US.

Potential Consequences of a Downgrade of the US Sovereign Rating

Standard and Poor’s (NYSE:MHP), Moody’s (NYSE:MCO), and Fitch have all raised concerns regarding the difficult political negotiations around increasing the debt limit and the need to address the sizable medium-term structural budget imbalance. That said, the three major rating agencies have three different views on their US rating:

Moody’s placed its US rating on review for possible downgrade on July 13, mainly because of the failure to reach an agreement on the debt limit. At the time, Moody’s indicated that while an AAA rating would likely be affirmed following the debt limit increase, the outlook assigned to the rating would very likely be changed to negative unless substantial long-term deficit adjustment was agreed along with the debt limit increase.

Fitch has not changed its rating or outlook on its US sovereign rating, but indicated that it would assign a rating of watch negative if the August 2 deadline is reached without lifting the debt ceiling.

S&P has taken the most negative stance on the fiscal situation thus far. It assigned a negative outlook to the US sovereign rating on April 18. At that time, it noted concerns that policymakers might not address medium- and long-term fiscal imbalances, and that “if an agreement is not reached and meaningful implementation does not begin by [2013], this would in our view render the US fiscal profile meaningfully weaker than that of peer AAA sovereigns.” On July 14, S&P put its US long-term and short-term ratings on CreditWatch negative, meant to signal a one in two chance of a downgrade within 90 days. In changing its stance after only three months, S&P cited the fact that the political debate had become “more entangled.” S&P indicated that it would likely downgrade its US rating if an adequate deficit reduction package were not achieved when the debt limit is increased, given their political assessment that if an agreement were not reached now it would not be reached for “several more years.” However, S&P left one potential option open: it stated that it would not downgrade its US rating even if a debt ceiling agreement does not include a plan to stabilize the medium-term fiscal outlook, if “the result of debt ceiling negotiations leads us to believe that such a plan could be negotiated within a few months.”

We expect the rating agencies will use two primary criteria to evaluate the eventual debt limit agreement:

Debt limit uncertainty: Proposals that increase the debt limit for a longer period appear to have a better chance of leading to more positive rating outcomes, by reducing uncertainty regarding interest and principal payments. This implies that an increase in the debt limit of $2.4 trillion that occurs in two stages would, all things being equal, pose more risk to the US AAA rating than a single increase of $2.4 trillion.

Medium-term fiscal stabilization of debt trajectory: In order to maintain their AAA ratings and return to a stable outlook, S&P and Moody’s have indicated that a deficit reduction package of roughly $4 trillion over ten years would need to be agreed to by Congress. The primary measure of stability in debt dynamics that the rating agencies are likely to look for is stabilization of the debt-to-GDP ratio by mid-decade. This is similar to the G20 declaration in 2010 that debt-to-GDP ratios should be stabilized or in decline by 2016. In practice, this should essentially require the primary deficit to be eliminated by that time. In the US, this would imply a 6% of GDP improvement in the structural fiscal balance over five years.

The dilemma that lawmakers face is that it is difficult to structure a bill that meets both of these goals at this late stage. Discretionary spending caps can work, but can’t generate enough savings on their own to stabilize the medium-term fiscal trajectory. In order to do that, policy changes are necessary beyond simple caps on appropriations bills, which can be effective but are limited in how much savings they can reasonably be expected to produce. Developing other policies takes time, particularly if they involve structural reforms to entitlement programs or the tax code, but Congress has only until August 2, according to the Treasury.

To address this, both parties propose to establish fiscal committees to develop additional reforms, which Congress would be required to vote on before the end of this year. However, without a credible enforcement mechanism, a committee could easily fail to agree or Congress could fail to vote on its recommendation. In that case, the likelihood that such a process would produce real savings declines considerably. But while a second debt limit vote later this year or early next year is the most obvious type of credible enforcement mechanism, it prolongs uncertainty regarding the debt limit. An alternative is to set automatic spending cuts or tax increases to take effect if the targeted savings are not achieved, but this requires political agreement on the ratio of savings from revenues vs. spending that is unlikely to be reached in the next few days.

The upshot is that the ratings reaction to the plan that will hopefully be enacted in coming days is likely to depend not only on the headline savings achieved, but also on the balance between the uncertainty that the chosen enforcement mechanism creates on the one hand, and the credibility that it provides to the reform process on the other hand. Unfortunately, the relative importance of these factors to the rating agencies (and S&P in particular) is unclear, as is how much other “soft” factors – such as the breadth of political support for the agreement for the agreement – will weigh in their decision.

A downgrade should not force sale of Treasuries

If one of the rating agencies does decide to downgrade the US sovereign rating, we see three main direct effects:

Knock-on downgrades. Rating agencies are likely to downgrade the ratings of some issuers that are closely linked or directly backed by the US government. The most obvious candidates are Fannie Mae and Freddie Mac, which are under conservatorship and rely on federal financial support. Fannie and Freddie MBS benefit from an implicit guarantee but are not rated, though they could still be affected. Ginnie Mae securities on the other hand, are directly backed by the federal government, and would likely be downgraded. AAA-rated Federal Home Loan Banks (FHLBs) don’t rely on federal capital or financing, but would also be downgraded in the event of a sovereign downgrade, according to S&P. AAA-rated insurers would as well, in light of S&P’s policy of not rating insurers higher than sovereigns of the same jurisdiction. Highly rated bank holding companies and bank subsidiaries could also be subject to downgrade, since some benefit from ratings “lift” above the banks standalone strength; while S&P has indicated that it would not immediately downgrade any banks or broker dealers in relation to a sovereign downgrade, Moody’s has indicated that it might in the event that it downgraded its US sovereign rating.

Collateral effects. The primary issue here is the repo market, since AA-rated Treasury and agency securities could face slightly higher haircuts, either as a result of a possible downgrade or as an indirect result of volatility that results from a downgrade. In the broader repo market, Treasuries are the dominant form of collateral, though in the tri-party repo market, agency MBS and CMOs comprise a greater share of the total collateral used (roughly 40%) than Treasuries (30%) and GSE debt (9%) do. In the event of a downgrade, it is reasonable to expect that the haircut on these securities might rise by up to one percentage point (the New York Fed estimates the median haircut for Treasuries and agency debt and MBS is currently 2%). Treasuries, and to a lesser extent agency securities, are also used for derivatives margining, though the aggregate amounts are much smaller. This would cause a modest contraction in available funding; 1% of an estimated $1.7 trillion tri-party repo market, of which 80% relies on government securities, would reduce funding using current collateral by $14 billion.

Capital requirements and investment mandates. In general, it is unlikely that a downgrade would result in significant pressure on regulated entities to shift assets out of Treasuries or agency securities, though it is conceivable that there may be some isolated areas where this could occur. In general, as shown in the table below, regulatory requirements often treat government securities as a separate asset class. Moreover, regulatory constraints typically would not come into play if a downgrade were only of one or two notches, to the AA+ or AA level. Likewise, a downgrade by only one rating agency is less likely to trigger such a reaction than a downgrade by two rating agencies. What happens to the significant portion of Treasury and agency securities held by foreign investors is a more complex question given a diversity of mandates – a few of these might rely on ratings – versus the deeper liquidity of the US government securities compared with any alternative investment, and the fact that a good deal of foreign holdings are the byproduct of the buildup of reserves in growth economies, particularly in Asia, that are generating large current account surpluses.

Holders of Treasury and agency debt, and implications of a potential downgrade

Source: Federal Reserve, GS Global ECS Research.

How would a US sovereign rating downgrade affect asset markets?

We will offer some general thoughts here from recent experiences from a few developed economies—data are better than no data–but two important caveats must be stated up front.

First, the size of the United States economy and Treasury market and the dollar’s status as a reserve currency make it impossible to find a clear historical parallel for the current situation. We examined three countries in particular. The three largest rating agencies downgraded Japan’s local-currency debt in the 1998-2001 period; this provides a relatively good comparison in terms of the size of the economy and debt market, but the holders of Japanese government debt were even at the time overwhelmingly domestic, whereas about half of Treasury debt is currently held abroad. Another recent example of a major economy losing AAA status is Spain, which was downgraded by S&P in 1998 and then again (after being upgraded in the interim) in 2009; Moody’s downgraded Spain from Aaa in 2010. Of course, the lack of its own currency and control over its own monetary policy—among other differences—complicates the analogy to the United States. Moody’s downgraded Canadian debt in June 1994; this is obviously closer geographically and in terms of foreign ownership, but is a considerably smaller economy and debt market. One could argue that the sheer size of the US Treasury market would make it harder for investors to diversify away, dampening the effect on Treasury yields or other US asset prices relative to the experience of other countries; alternatively, perhaps a downgrade of a sovereign so central to the global economy could have greater-than-expected repercussions on confidence or risk appetite more broadly.

Second, in our commentary on market reactions we do not attempt to control for other country-specific news or economic data; such an exercise is beyond the scope of this daily comment. While we believe those factors should more or less cancel out across our examples as a whole, our sample represents just a few events and so we warn that the signal-to-noise ratio is low.

With those warnings in mind, we suspect we would see the following reactions to a US downgrade:

A drop in equity markets, but probably a modest one. Equities usually but not always dropped on the day of downgrade; a further drift down of a few percent over the subsequent month was typical. But the average drop in the equity market was less than 1% on the day, and there were exceptions over both the 1-day and 1-month horizons. Part of the reason for this—and the often mild moves in other asset classes—is undoubtedly that the debt issues had long been on the market’s radar and the potential for a downgrade was known, though we had trouble finding a clear pattern in the behavior of equities in the months leading up to the downgrade.

Some weakening in the currency. The yen dropped by more than 1% versus the dollar on two of the downgrade episodes; moves in the other cases were very small. Given the large foreign holdings of Treasuries, it would not be surprising to see a somewhat bigger effect on the dollar in the event of a US downgrade, although we would be surprised by a move of more than a few percent. The effect on the currency could also be mitigated by repatriations of foreign assets to increase cash holdings.

A steepening of the yield curve and a cheapening of Treasuries relative to OIS. The Japan, Canada, and Spain episodes showed no clear pattern in ten-year yields or spreads to US Treasuries. This may be because downgrades imply two opposing forces: a heightened premium for holding government debt, which pushes yields higher, but more pressure for fiscal austerity, which would slow growth (at least in the near term) and pushes yields lower. This tug-of-war was evident earlier this year when Standard & Poor’s changed its US rating outlook to negative: ten-year Treasury yields ended the day little changed. Standard & Poor’s has indicated an expectation of a 25-50bp increase in “long-term” US interest rates in the event of a downgrade; this is certainly possible at the very long end of the curve,, but we suspect the impact on the ten-year note would be smaller, at least initially. One clearer implication is a curve steepening, since the impact of austerity is disproportionately felt at the front end of the curve whereas the heightened risk premium is most significant at the long end. This effect could be reversed (i.e., more front-end weakness) if the US were to go into a “technical default,” but we view this as a very remote scenario. Relative to the expected path of short-term interest rates (i.e., OIS), we would expect Treasuries to cheapen somewhat further (currently, 10-year Treasuries trade 20bp above corresponding maturity OIS).

Some weakness in the financials sector. In the event of a US sovereign downgrade, S&P has indicated that AAA insurers, the GSEs, and the Federal Home Loan Banks would be downgraded as well. Although a recent S&P statement suggested that “banks and broker-dealers wouldn’t likely suffer any immediate ratings downgrades,” an increased premium on sovereign debt could result in some indirect impact on debt and equity of financial firms beyond those insurers directly affected.

It bears repeating that no two episodes are alike – nor is any historical episode a close parallel to current US circumstances. So uncertainty about market effects is high. The above moves probably imply a net tightening in financial conditions, although dollar weakening would provide at least a partial offset to lower equity prices and/or higher yields. Consumer confidence, which may already be suffering from concerns about the debt ceiling extension (see the July 19 US Daily for more details), could well take a further hit in the event of a downgrade. Tighter financial conditions and lower confidence imply lower economic growth, but even in a scenario where equities decline by five percent, 10-year yields rise by 25bp, and the dollar declines by three percent – all are bigger moves than we would expect to see – financial conditions would tighten by only about 50bp, with a GDP growth effect of similar or slightly smaller magnitude.